Recently, Ben Holt, Blades chief financial officer, has assessed whether it would be more beneficial for Blades to establish a subsidiary in Thailand to manufacture roller blades or to acquire an existing manufacturer, SkatesnStuff, which has offered to sell the business to Blades for 1 billion Thai baht. In Holts view, establishing a subsidiary in Thailand yields a higher net present value than acquiring the existing business. Furthermore, the Thai manufacturer has rejected an offer by Blades, Inc., of 900 million baht. A purchase price of 900 million baht for SkatesnStuff would make the acquisition as attractive as the establishment of a subsidiary in Thailand in terms of NPV SkatesnStuff has indicated that it is not willing to accept less than 950 million baht. Although Holt is confident that the NPV analysis was conducted correctly, he is troubled by the fact that the same discount rate, 25 percent, was used in each analysis. In his view, establishing a subsidiary in Thailand may be associated with a higher level of country risk than acquiring SkatesnStuff. Although either approach would result in approximately the same level of financial risk, the political risk associated with establishing a subsidiary in Thailand may be higher than the political risk of operating SkatesnStuff. If the establishment of a subsidiary in Thailand is associated with a higher level of country risk overall, then a higher discount rate should have been used in the analysis. Based on these considerations, Holt wants to measure the country risk associated with Thailand on both a macro and a micro level and then to re-examine the feasibility of both approaches.Page 2 of 4 First, Holt has gathered some more detailed political information for Thailand. For example, he believes that consumers in Asian countries prefer to purchase goods produced by Asians, which might prevent a subsidiary in Thailand from being successful. This cultural characteristic might not prevent an acquisition of SkatesnStuff from succeeding, however, especially if Blades retains the companys management and employees. Furthermore, the subsidiary would have to apply for various licenses and permits to be allowed to operate in Thailand, whereas SkatesnStuff obtained these licenses and permits long ago. However, the number of licenses required for Blades industry is relatively low compared to other industries. Moreover, there is a high possibility that the Thai government will implement capital controls in the near future, which would prevent funds from leaving Thailand. Because Blades, Inc., has planned to remit all earnings generated by its subsidiary or by SkatesnStuff back to the United States, regardless of which approach to direct foreign investment it takes, capital controls may force Blades to reinvest funds in Thailand. Holt has also gathered some information regarding the financial risk of operating in Thailand. Thailands economy has been weak lately, and recent forecasts indicate that a recovery may be slow. A weak economy may affect the demand for Blades products, roller blades. The state of the economy is of particular concern to Blades because it produces a leisure product. In the case of an economic turndown, consumers will first eliminate these types of purchases. Holt is also worried about the high interest rates in Thailand, which may further slow economic growth if Thai citizens begin saving more. Furthermore, Holt is also aware that inflation levels in Thailand are expected to remain high. These high inflation levels can affect the purchasing power of Thai consumers, who may adjust their spending habits to purchase more essential products than roller blades. However, high levels of inflation also indicate that consumers in Thailand are still spending a relatively high proportion of their earnings. Another financial factor that may affect Blades operations in Thailand is the bahtdollar exchange rates. Current forecasts indicate that the Thai baht may depreciate in the future. However, recall that Blades will sell all roller blades produced in Thailand to Thai consumers. Therefore, Blades is not subject to a lower level of U.S. demand resulting from a weak baht. Blades will remit the earnings generated in ThailandPage 3 of 4 back to the United States, however, and a weak baht would reduce the dollar amount of these translated earnings. Based on these initial considerations, Holt feels that the level of political risk of operating may be higher if Blades decides to establish a subsidiary to manufacture roller blades (as opposed to acquiring SkatesnStuff). The financial risk of operating in Thailand will be roughly the same whether Blades establishes a subsidiary or acquires SkatesnStuff. Holt is not satisfied with this initial assessment, however, and would like to have numbers at hand when he meets with the board of directors next week. Thus he would like to conduct a quantitative analysis of the country risk associated with operating in Thailand. He has asked you, a financial analyst at Blades, to develop a country risk analysis for Thailand and to adjust the discount rate for the riskier venture (i.e., establishing a subsidiary or acquiring SkatesnStuff). Holt has provided the following information for your analysis: Because Blades produces leisure products; it is more susceptible to financial risk factors than political risk factors. You should use weights of 60 percent for financial risk factors and 40 percent for political risk factors in your analysis. You should use the attitude of Thai consumers, capital controls, and bureaucracy as political risk factors in your analysis. Holt perceives capital controls as the most important political risk factor. In his view, the consumer attitude and bureaucracy factors are of equal importance. You should use interest rates, inflation levels, and exchange rates as the financial risk factors in your analysis. In Holts view, exchange rates and interest rates in Thailand are of equal importance, while inflation levels are slightly less important. Each factor used in your analysis should be assigned a rating in a range of 1 to 5, where 5 indicates the most unfavourable rating. Holt has asked you to provide answers to the following questions for him, which he will use in his meeting with the board of directors:

Which method of direct foreign investment should utilize a higher discount rate in the capital budgeting analysis? Would this strengthen or weaken the tentative decision of establishing a subsidiary in Thailand? [10 Marks]